Lecture 11: Consumption, Saving and Investment II

1. Lecture 11: Consumption, Saving and Investment II L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.7 16 February 2010

2. Introduction • Last time: • Modelled household consumption and saving decision • Examined impact of changing income and interest rates on household consumption • Today • Consumption decisions imply a level of saving • What does this imply for capital accumulation?

3. Consumption Over Many Periods • Considered a 2-period consumption decision: • Assumed that period 2 was the last period • Now extend to many periods • So end-of-period two assets no longer fixed

4. Beyond Two Periods • If we extend l.h.s beyond two periods: • And extend rhs beyond two periods: • Final term disappears because there is no ‘end’ period

5. Multiyear Budget Constraint • So the ‘multiyear’ constraint is: • This constraint covers multiple periods: ultimately covers a household’s lifetime present value of consumption = value of initial assets + present value of wage increases

6. Temporary vs Permanent Changes • Over the lifetime of a household, temporary vs permanent changes in income will have different effects • A temporary change in income (e.g. in period 2 only) raises overall resources by a small amount • The household wants to keep consumption smooth, so it spreads the extra resource over all time periods • So the impact on consumption now is small, the propensity to consume is less than 1

7. Temporary vs Permanent Changes • Permanent changes in income have a much bigger effect on current consumption • Income rises in all periods • So consumption rises in all periods in line with the increase in income • The propensity to consume now out of the increase in income is 1. • Key issue: an increase in income of £100 today doesn’t raise consumption today by £100 unless it is permanent.

8. Expected vs Unexpected Income • Whether income is expected also matters • If households expect a higher future income, they will factor this into their borrowing decisions and plan for higher income. • So when income increases between periods, if it was expected it has no impact on consumption • But if households receive an unexpected increase in income, this will impact of consumption.

9. Consumption and Investment • One-period budget constraint • Interest rate • This is true for all households • Across all households, B and ΔB must sum to zero • So can drop from this equation in aggregate

10. Consumption and Investment • Also, know that in equilibrium all income is paid to labour and capital: • So can reduce to • Net investment depends on consumption. If consumption is lower, investment will be higher • This is crucial: it completes the picture of how household choices determine investment consumption + net investment = real GDP - depreciation

11. Review of Macro Model • Brief review of last 4 lectures • Want a model of the macroeonomy in order to understand what might drive fluctuations and how they impact on the economy • Model based on ‘microfoundations’ of how consumers, producers, workers and capital owners behave

12. Review I • Constructed model based on ‘household’ • Household owns a small business, supplies labour, supplies capital and consumes • So captures all the essential elements of the economy • Households are price takers: markets are perfectly competitive and continually in equilibrium

13. Review II • We setup what households ‘do’ in via the budget constraint • They earn profit, wage income, rental income and income from bonds • They use it to consume, save for the future and invest in more capital

14. Review III • We then set out to explain how much income they earn and what they do with it • Production: by profit-maximisation, households combine factors of production to produce output • In perfectly competitive market the business makes no profit, but factors of production (supplies by the household) earn rents • Exactly the same as in microeconomic model

15. Review IV • … and what they do with it • They spend some and save some, aiming to smooth their consumption • This decision is made over many periods • So consumption depends on overall lifetime wealth, not just wealth today • How much they save determines how much is invested in capital (and so how much output is produced in the future)

16. Review V • Does this model explain reality? • Sounds plausible, consistent with microeconomics • Has implications for what will happen in the economy when variables change • Next step: incorporate changes in technology • We found they explained long-run growth • Maybe changes in technology could also explain fluctuations • But only if our model’s predictions are supported by data

17. Summary • Completed the macro model • Has some limitations (fixed labour and capital supply) • But now used to address the data • Next time: have a closer look at the data on fluctuations • Are the prediction of our model consistent with what we see in the data?